The big danger that many people fear is that economic recovery will cause
inflation to rise - after all, that is supposed to be the normal relationship

For those of us who have been forecasting inflation to fall to low levels, the past few years have been a trying time. But we are now able to enjoy a small bit of vindication. On the latest figures, inflation has fallen back to the target of 2pc for the first time for four years. Is it now likely to give us a run of favourable surprises? Or was the latest figure a flash in the pan?

We all know the factors that have driven inflation higher over the past few years: sharp rises in commodity prices, the big fall of the pound, VAT rises, falling productivity and increases in administered prices. But why did it stay so stubbornly high? There has been a lingering suspicion that Britain was returning to its old inflationary habits. Bear in mind that at the start of 2013 the Bank of England, in common with many forecasters, expected inflation to end the year at 3pc. So for it to come in at 2pc is especially welcome.

There are now several reasons to think that inflation will fall further. For a start, the Government has decided to ease the pressure on living standards by scaling back rises in administered prices. In the Autumn Statement, the Chancellor scrapped the planned rise in fuel duty and above inflation increases in rail fares; and environmental levies paid by utility companies have been reduced. Meanwhile, the weakness of agricultural commodity prices should cause food price inflation to fall below 1pc.

Moreover, factory gate prices have recently been extremely weak. These tend to feed through to prices in the shops with a lag of about a year. Furthermore, low inflation abroad, coupled with the recent strength of the pound, means that the price of imported goods should fall this year.

Now, obviously this favourable picture could be scuppered by a sharp rise in oil or other commodity prices. There is always that risk. But a continued easing in these prices looks more likely.

I suppose the big danger that many people fear is that economic recovery will cause inflation to rise. After all, that is supposed to be the normal relationship. Clearly, there is something in this, particularly on a global level as the strength of demand drives commodity prices, which then have a major bearing on consumer prices.

But it has been striking that over the past year in the UK, strengthening growth has coincided with falling inflation. I suspect that, over a broad range of output, changes in demand don’t have much effect on inflation and might even cause it to change in a counter-intuitive direction. (This is the view that the famous Phillips Curve is flat, or even slightly downward sloping.)

When economists think of the relationship between output and prices they immediately conjure up an upward sloping supply curve, reflecting rising marginal costs. But many businesspeople don’t think that way at all. As output expands, average costs fall. The flipside is that as output falls, average costs rise since fixed costs have to be allocated over a lower volume of output. This is one reason why inflation has been surprisingly slow to fall when the economy was weak. The corollary may be that it will be surprisingly slow to rise as the economy recovers. Indeed, it may carry on falling.

Moreover, other factors may propel inflation lower. In the depths of the recession, the Bank of England came up with an interesting view as to why inflation remained so high. For many firms, whether or not to put up prices can be seen as an investment decision. Because the responsiveness of customers to higher prices is low in the short run, if prices are raised, the move will actually boost revenues and profits. But in the long run, responsiveness is greater and both revenue and profits may fall.

If firms can get the finance to tide them over the short run, the sensible thing will often be to keep prices down and benefit from the subsequent increase in volumes. But in the slump – when demand was weak, profits were low and bank finance was difficult to get hold of – firms did not have this luxury. They had to raise prices to survive. If there is anything in this idea then – as the economy recovers, profits rise and the banks become more willing to lend – firms’ pricing decisions will lean more in the direction of keeping prices down in order to keep volumes up.

Even so, there is another threat to low inflation - the labour market. As the economy recovers, wages could start to rise more smartly, thereby increasing firms’ costs and pushing them to try to increase prices. To some extent I think this will happen. But not much. Unemployment may be falling fast, yet it remains high. And all the signs are that the workforce is continuing to increase.

The upshot is that I could readily see CPI inflation falling this year to 1.5pc – and even 1pc looks perfectly plausible. Mind you, none of this squashes the medium-term inflation danger that I have highlighted here before. The danger is not the one that most people fear, namely that quantitative easing (QE) and the presence of large amounts of cash in the system will prompt a classic money-fuelled rise in prices. The excess cash can be frozen or be reabsorbed by a reversal of QE – if the authorities so desire. No, the danger I see is that the authorities may come to regard higher inflation as part of the solution, not the problem.

A deliberate policy of higher inflation has been urged by a battery of distinguished economists. The point is that, if done in the right way, a burst of higher inflation would reduce the debt burden, both government and private. It would also bale out what will by then surely be a seriously overblown housing market. By that stage a housing market crash might be a real risk – and with it the prospect of another financial crisis. Such inflation would surely be accompanied by, and might be prompted by, a sharp fall of the pound which is now getting seriously overvalued. So it could serve to correct more than one imbalance.

But for now, and probably for the next year or two, all this is merely a possibility over the horizon. In the meantime, the Government can bask in the combination of rising output and falling inflation. You too should enjoy it – while you can.